Question

Covan, Inc. is expected to have the following free cash​ flow:

Year	1	2	3	4
FCF	10	12	13	14	Grow by 4 % per year

a. Covan has 7 million shares​ outstanding,

​$2 million in excess​ cash, and it has no debt. If its cost of capital is 12%​,

what should be its stock​ price?

b. Covan adds its FCF to​ cash, and has no plans to add debt. If you plan to sell Covan at the beginning of year​ 2, what is its expected​ price?

c. Assume you bought Covan stock at the beginning of year 1. What is your expected return from holding Covan stock until year​ 2?

Answer 1

a. The stock price is computed as shown below:

= $ 10 / 1.12¹ + $ 12 / 1.12² + $ 13 / 1.12³ + $ 14 / 1.12⁴ + 1 / 1.12⁴ [ ( $ 14 x 1.04 )  / (0.12 - 0.04) ]

= $ 152.31 Approximately

Price = ( $ 152.31 + cash - debt ) / shares outstanding

= ( $ 152.31 + 2 - 0 ) / 7

= $ 22.04 Approximately

b. The expected price is computed as follows:

= $ 12 / 1.12¹ + $ 13 / 1.12² + $ 14 / 1.12³ + 1 / 1.12³ [ ( $ 14 x 1.04 )  / (0.12 - 0.04) ]

= $ 160.59 Approximately

Price = ( $ 160.59 + cash - debt ) / shares outstanding

= ( $ 160.59 + 2 - 0 ) / 7

= $ 23.23 Approximately

c. Expected return is computed as follows:

= ( $ 23.23 - $ 22.04 ) / $ 22.04

= 5.40% Approximately

Feel free to ask in case of any query relating to this question